Chapter 1

Thinking Like An Economist

Copyright c 2009 by The McGraw-Hill

Companies, Inc. All rights reserved.

Introduction

What is the Optimal Class Size?

To maximize learning without
consideration of cost?
How would considering costs change our
answer?
A personal tutorial course in economics
might cost $40,000
A class of 300 students might cost
$200/student

Introduction

What is the Optimal Class Size?

What trade-offs must university
administrators and students consider
when choosing class size?

Economics: Studying
Choice In a World of Scarcity

The Scarcity Principle

Boundless wants cannot be satisfied
with limited resources.
Therefore, having more of one thing
usually means having less of another.
Because of scarcity we must make
choices.

Economics: Studying
Choice In a World of Scarcity
Wants vs. Resources

Scarcity
Choices

Economics: Studying
Choice In a World of Scarcity

Economics
The study of how people make choices
under conditions of scarcity and of the
results of those choices for society.

Economics: Studying
Choice In a World of Scarcity

The Cost-Benefit Principle

An individual (or a firm or a society)
should take an action if, and only if, the
extra benefits from taking the action are
at least as great as the extra costs

Economics: Studying
Choice In a World of Scarcity

Choosing the Optimal Class Size

Revisited
Assumptions:
Two class sizes: 100 and 20
Introductory economics classes currently
have 100 students

Question

Should the class size be reduced to 20

students?

Economics: Studying
Choice In a World of Scarcity

Observations
The best class from an economic point
of view will generally not be the same as
the best size from the point of view of
an educational psychologist.
People will feel differently about the
value of smaller classes.

Economics: Studying
Choice In a World of Scarcity

Application
What other examples of scarcity and
trade-offs can we identify?

Economics: Studying
Choice In a World of Scarcity

Choosing the Optimal Class Size

Assume:

The cost of a class with 20 students is

$1,000 per student more than a class of 100
students

What do you think:

Would it be a good idea to reduce the class

size?

Applying The Cost-Benefit

Principle

Rational Person
Someone with well-defined goals who
tries to fulfill those goals as best he or
she can

Applying The Cost-Benefit

Principle

Should you walk downtown to save

$10 on a $25 computer game?
The benefit of going downtown = $10
The cost of going downtown is the dollar
value of everything you give up to go
downtown

Applying The Cost-Benefit

Principle

Should you walk downtown to save

$10 on a $25 computer game?
Estimating the cost:
How much would someone have to pay you
to walk downtown?
If you would walk downtown for $9; the
trips cost is $9

The benefit ($10) exceeds the cost of

($9) of buying the game downtown

Applying The Cost-Benefit

Principle

Question
Will everyone choose to buy the
computer game downtown?

Applying The Cost-Benefit

Principle

Economic Surplus
The benefit of taking any action minus
its cost
The goal of economic decision makers is
to maximize their economic surplus

Applying The Cost-Benefit

Principle

Opportunity Cost
The value of the next-best alternative
that must be forgone to undertake an
activity

Applying The Cost-Benefit

Principle

Question
What is the opportunity cost of buying
the game downtown?

Applying The Cost-Benefit

Principle

Assume
The benefit of buying the game
downtown is $10
The cost of making the trip is $12

Questions
What is your economic surplus from
buying the game downtown?
Where should you buy the game?

Applying The Cost-Benefit

Principle

The Role of Economic Models

Economic models are abstract
(simplified descriptions) models that
allow us to analyze situations in a logical
way
Other examples of abstract models
A computer model of climate change
A road map

Applying The Cost-Benefit

Principle

Observation
The cost-benefit principle suggests that
we take only those actions that create
additional economic surplus.

Four Important Decision

Pitfalls

Pitfall 1: Measuring cost and benefits as

proportions rather than
absolute dollar amounts
Examples:
Should you walk downtown to save $10 on
a $2,020 laptop computer?
Which is more valuable, saving $100 on a
$2,000 plane ticket to Tokyo or saving $90
on a $200 plane ticket to Chicago?

Four Important Decision

Pitfalls

Pitfall 2: Ignoring Opportunity Costs

Example:

Should you use your frequent-flyer coupon

to fly to Fort Lauderdale for spring break?

Assume:
Round trip airfare is $500 and is equal to
your frequent flyer coupon
Other costs equal $1,000

Four Important Decision

Pitfalls

Pitfall 2: Ignoring Opportunity

Costs
Assume (cont):
The most you are willing to pay for the
Fort Lauderdale trip is $1,350
Alternate use for the frequent flyer
coupon is to attend a wedding in Boston
the week after spring break and the
Boston airfare is $400 (coupon expires
just after the wedding)

Four Important Decision

Pitfalls

Pitfall 2: Ignoring Opportunity Costs

Example:

Should you use your frequent flyer coupon to fly to

Fort Lauderdale for spring break?

Without the coupon:

Benefits = $1,350
Cost = $1,400 ($400 opportunity cost + $1,000
other costs)

Question

What would you do if the coupon expires just after

spring break?

Four Important Decision

Pitfalls

Pitfall 2: Ignoring Opportunity Costs

The key to using the concept of
opportunity cost correctly lies in
recognizing precisely what taking a
given action prevents us from doing.

Four Important Decision

Pitfalls

Pitfall 3: Failure To Ignore Sunk

Costs
The only costs that should influence a
decision about whether to take an action
are those that we can avoid by not
taking the action

Four Important Decision

Pitfalls

Pitfall 3: Failure To Ignore Sunk

Costs
Sunk cost

A cost that is beyond recovery at the

moment a decision must be made

Four Important Decision

Pitfalls

Pitfall 3: Failure To Ignore Sunk

Costs
Example

How much should you eat at an all-you-caneat restaurant?

Assume:
Price = $5
20 randomly selected guests will get lunch
on the house

Four Important Decision

Pitfalls

Pitfall 3: Failure To Ignore Sunk

Costs
Example

How much should you eat at an all-you-caneat restaurant?

Question:

If all diners are rational, will there be any

difference in the average quantity of food
consumed by these two groups?

Four Important Decision

Pitfalls

Pitfall 4: Failure To Understand the

Average-Marginal Distinction
Marginal Benefit

The increase in total benefit that results

from carrying out one additional unit of an
activity

Four Important Decision

Pitfalls

Pitfall 4: Failure To Understand the

Average-Marginal Distinction
Marginal Cost

The increase in total cost that results from

carrying out one additional unit of an activity

Four Important Decision

Pitfalls

Pitfall 4: Failure To Understand the

Average-Marginal Distinction
Example
Should NASA expand the space shuttle
program from four launches per year to five?
Benefits

$24 billion (average of $6 billion/launch)

Costs
$20 billion (average of $5 billion/launch)

Four Important Decision

Pitfalls

Pitfall 4: Failure To Understand the

Average-Marginal
Distinction
Average Cost

The total cost of undertaking n units of an

activity divided by n

Four Important Decision

Pitfalls

Pitfall 4: Failure To Understand the

Average-Marginal
Distinction
Average Benefit

The total benefit of undertaking n units of

an activity divided by n

Four Important Decision

Pitfalls
# of Launches
0

Total Cost

Average Cost

Marginal Cost

($ billion)

($ billion/launch)

($ billion/launch)

3.5

3
4
5
8
12

3
4

12

What is the optimal number of launches?

20
5

Assume: Average Benefit = Marginal

Benefit = $6 billion
5

32

6.4

Normative Economics
vs. Positive Economics

Normative Economic Principle

One that says how people should behave

Example: Cost-benefit principle

Positive Economic Principle

One that predicts how people will behave

Example: The incentives matter principle

A person (or a firm or society) is more likely to
take an action if its benefit rises and less likely if
its cost rises)

Economics:
Micro and Macro

Microeconomics
The study of individual choice under
scarcity and its implications for the
behavior of prices and quantities in
individual markets

Economics:
Micro and Macro

Macroeconomics
The study of the performance of
national economies, and of the policies
that governments use to try to improve
that performance

The Approach of This Text

Focus on core economic concepts

Scarcity principle
Cost-benefit principle
Incentive principle
Learning economics through
applications

Economic Naturalism

Using insights from economics to

help make sense of observations
from everyday life

Economic Naturalism

Question
Why do so many computer hardware
manufacturers include more than
$1,000 worth of free software with a
computer selling for only slightly more
than that?

Economic Naturalism

Questions
Why dont automobile manufacturers
make cars without heaters?
Why do the keypad buttons on drive-up
automatic teller machines have Braille
dots?

Economic Naturalism

Applications
Use cost-benefit analysis to explain
some pattern of events or behavior you
have observed in your own environment